The use of non-linear derivatives has become a widespread instrument and vital tool in the financial markets over the last thirty years, ever since the Black-Scholes formula for calculating the price of options was introduced in 1973. As with all non-linear derivatives created since that time, one of the fundamental aspects to trading such financial instruments is the pricing of the option, or what is known as the “premium.” Many variations of the Black-Scholes formula have been proposed and implemented, particularly formula variations that take into account the aspects of American-style options. Furthermore, many variations of options derivatives have been devised, including exotic options of varying characteristics and parameters. Regardless of the parameters of these non-linear derivatives, they are typically subject to a premium that is tied to the underlying financial instrument, be that underlying instrument a stock issue, stock index, currency instrument or futures instrument. Indeed, there are even non-linear derivatives on linear derivatives in the form of options on futures.
Despite the fact that non-linear derivatives are largely designed as a hedging instrument for mitigating risk, the potential for sizable losses still exists if a non-linear derivative such as so-called “plain vanilla option” expires “out of the money” and the entire cost of the premiums lost, or even when such an option expires “in the money” but the final value of the option is less than the original premium paid. In other words, if expectations for the performance of an underlying instrument within a designated time frame do not meet a minimum criteria, at least some portion of the cost of the option premium will be lost. Still, one of the reasons non-linear derivatives, specifically options, offer so much appeal is because one will always know exactly the maximum amount of downside risk before taking a position—the cost of the premium—while the potential upside is theoretically limitless.
However the theoretically limitless gains that can be realized in an options position usually has a topside implied by the volatility of the underlying instrument. Furthermore, because the cost of a premium is always at risk of losing value, traders have devised elaborate hedging strategies such as “delta hedging” to mitigate the risk of lost value. In other words, they are hedging against hedging strategies, creating financial maneuvers that can become very intricate, confusing and speculatively hazardous. These shortcomings of non-linear derivatives highlight the need for a simpler and safer hedging, leveraging and speculating strategy on the movement of underlying financial instruments.